What are Exchange Traded Funds (ETFs)?
Exchange traded funds (ETFs) are index funds or trusts that are listed on an exchange and can be traded intraday. Investors can buy or sell shares in the collective performance of an entire stock or bond portfolio as a single security. Exchange traded funds add the flexibility, ease and liquidity of stock trading to the benefits of traditional index fund investing.
Most ETFs are listed on the American Stock Exchange. ETFs are available on more than 100 broad stock market, stock industry sector, international stock, and U.S. Treasury, and corporate bond indexes, providing a wide array of investment opportunities. ETFs provide a simple and effective way to invest in equity markets worldwide and the U.S. bond market. Investors can establish long-term investments in the market performance of the leading companies in the leading industries in the United States or abroad, or tailor asset allocations using diversified investments in stocks in particular industries or countries or in U.S. bonds.
We are now updating our ETF Investing Portfolios once a month when we update our investing newsletter. For most asset classes, we now prefer investing in Exchange Traded Funds rather than Mutual Funds. This is an alternative or supplemental approach to Mutual Fund investing. ETFs should not be used for dollar cost averaging. They should be used when your portfolio is large enough to buy at least 100 shares of each of these exchange traded funds so that you don’t spend too much in commissions to implement these investment strategies. Check out our list of exchange traded funds for the Our 100 Favorite ETFs to Follow.
What are the advantages of ETFs?
ETFs offer tax benefits similar to index funds because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors. Keep in mind that an investor selling ETF shares may realize capital gains or losses, as with common stocks.
Expenses can have a significant impact on returns for investors. ETFs, in general, have significantly lower annual expense ratios than other investment products. ETFs are less likely to experience high management fees because they are index-based, not “actively” managed. Since they trade on an exchange, ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. While the fact that the purchase or sale of exchange traded funds are subject to brokerage commissions could be considered a drawback, the low commissions of discount brokerages make these fees insignificant.
ETFs are designed to generally replicate the holdings and correspond to the performance and yield of their underlying index.
Buying and Selling Flexibility
ETFs can be bought and sold at intraday market prices throughout the day. They are not restricted to once-a-day trading at the end of the day like mutual funds. In addition, ETFs can be purchased on margin, sold short, and traded using stop orders and limit orders.
Since each ETF is comprised of a basket of securities, most inherently provide diversification across an entire index, or at least an industry sector. The ever expanding universe of ETFs offers exposure to a diverse variety of markets, including:
- broad-based equity indexes (total market, large-cap growth, and small-cap value)
- broad-based international and country-specific equity indexes (Canada, Europe, and Emerging Markets)
- industry sector-specific equity indexes (such as technology, energy, and real estate)
- U.S. bond indexes (such as US Treasury bonds and corporate bonds)
Dividends paid on company stock and interest paid on bonds held in an ETF are distributed to ETF holders, less expenses. Since some companies do not pay dividends, distributions from some ETFs may be negligible.
Broad selection of Investment Strategies
Investors can capitalize on the convenience and flexibility of ETFs to pursue a wide variety of investment strategies.
Core Investment – Investors can use ETFs as a core investment for their portfolio. The purchase of shares in a single ETF can provide broad market exposure of a portfolio of stocks or bonds for long-term holding that is easy to establish, easy to track, inexpensive, and tax efficient.
Portfolio Diversification – ETFs cover virtually every segment of the equity markets and several segments of the U.S. bond market, providing an easy and convenient way to adjust the investment mix of a core portfolio.
Hedging – Exchange traded funds can be purchased on margin and sold short (even on a downtick), which has opened up risk management strategies for individual investors that were once available only to large institutions. For example, ETFs can be sold short to hedge a core stock portfolio or interest rate fluctuations. This allows investors to keep their portfolio intact while protecting it from market losses. In a declining stock market or rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. Listed options, available on some ETF products, also offer opportunities for additional hedging or to increase income. Investors should contact their broker regarding initial and maintenance margin requirements for these strategies.
Rebalancing – Investors can adjust ETF positions at any time throughout the trading day, without redemption fees or short-term restrictions. Again, brokerage commissions will apply.
Risks and Other Considerations
ETF shareholders are subject to risks similar to those of holders of other diversified portfolios.
A primary consideration is that the general level of stock prices may decline, thus affecting the value of an equity exchange traded fund. This is because an equity ETF represents interest in a portfolio of stock.
Another important consideration is that the general level of bond prices may decline, thus affecting the value a fixed income exchange traded fund. This is because a bond ETF represents interest in a portfolio of bonds. When interest rates rise, bond prices generally will decline, which will adversely affect the value of fixed income ETFs.
An exchange traded sector fund may also be adversely affected by the performance of that specific sector or group of industries on which it is based.
International investments may involve risk of capital loss from unfavorable fluctuations in currency values, differences in generally accepted accounting principles, or economic, political instability in other nations.
Although exchange traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors.